1. Financial Market Theory
Thursday, August 31, 2017
Professor Edwin T Burton

2. Readings, So Far (Available on Collab)
You should have already read Malkiel, “A Random Walk Down Wall Street”
During last week, you should have read Chapters One and Two
This week, you should read Chapters Three and Four
August 31, 2017

3. Debt and Equity Assets = Liabilities + Net Worth = Debt + Equity
Balance Sheet
As of August 31, 2017
Assets
Liabilities (Debt)
Net Worth (Equity)
Assets = Liabilities + Net Worth = Debt + Equity
August 31, 2017

4. More on “Bankruptcy”
Two Main Types of Bankruptcy (defined in US Federal Code)
Chapter 7 (chapter refers to section of US Federal Code)
Liquidation of assets, pay off liabilities as best one can
End of company
Chapter 11
Temporary suspension of all debt payments (and some other bills) {this is called “bankruptcy protection”
Formation of “creditors’ committee” approved by Federal bankruptcy court
Restructure of right hand side o the balance sheet
Emerge (hopefully) from bankruptcy as NEWCO
August 31, 2017

5. Main Point of Chapter 11 Bankruptcy
Mainly a reorganization of the right hand side of the balance sheet
Outstanding debt “converted” into new debt, new equity in NEWCO
Must be approved by debt holders and the courts
Assets may or may not be affected
Emerging company is usually financially much stronger than previous company because debt payments have been substantially reduced
Most recent examples are in the energy industry, where large numbers of company sent into Chapter 11 bankruptcy and many have already emerged
Sometimes, the reorganization of the balance sheet is done prior to filing for Chapter 11 with the approval of equity and debt holders. Basically, this “reorg” simulates a court-approved bankruptcy that would have occurred if the company had gone through Chapter 11 bankruptcy
August 31, 2017

6. Stock Returns How are they calculated? Two components:
Capital Gains (change in stock price during the period divided by beginning of period stock price): (Pt – Pt-1)/Pt-1
Dividends Paid During the Period (typically every three months in a regular pattern)
Many companies do not pay dividends and have no plans to do so (mostly technology companies)
August 31, 2017

7. Why Pay Dividends?
After all, investors have to pay taxes on dividends, but not on “unrealized” capital gains
So, make some of the return taxable?
Famous Modigliani-Miller “Theorem” on Dividends: “Dividends are Irrelevant”
Uses concept of “enterprise value” of the firm
Theorem: in world of no taxes, whether or not a firm pays dividends has no effect on the firm’s enterprise value
If there are taxes, there is a “tax shield on interest expense” that suggests higher leverage may be optimal
August 31, 2017